On December 5th, we previewed Lululemon’s Q3 earnings and detailed a stock alternative for those considering a defined risk way to play for a post earnings breakout of its nearly two month consolidation. Here was the trade idea and rationale:
LULU certainly looks like a chart that could be bottoming. But the stock has shown massive volatility in the past and defining risk for those looking to play for a breakout from the range is the smart move.
Defined Risk Stock Alternative in lieu of 100 shares of LULU (57.75)
LULU (57.75) Buy the Jan 57.50/67.50/77.50 call fly for 2.50
- Buy 1 Jan 57.5 call for 4.50
- Sell 2 Jan 67.5 calls at 1.10 (2.20 total)
- Buy 1 Jan 77.5 call for .20
Rationale – This trade defines risk to just 2.50. That’s less than half the event risk in the stock itself with a $5.50 implied earnings move either way. On a big move lower this will suffer losses but it’s unlikely to be worthless and is much better than being long stock. On a move higher the ideal situation is for the stock to be at or near 67.5 on Jan expiration. A move higher and not all gains are realized obviously, so patience is a virtue. But it will be a nice winner anywhere above it’s break-even point and vol will come in hard which will help with gains above the break-even.
The stock is now higher by more than $10, it was a coiled spring. One issue with defining risk with a call butterfly is that not all the gains are realized immediately, and some patience is in order. So I wanted to go over the stock alternative and see what its profits are now, and how much could additionally could be expected with some patience.
The first thing to look at is the targeted area for the move. The center of the fly is 67.50, and that is the ideal spot on an expiration. Of course LULU gapped even higher than that on a massive move. That’s not terrible, as this trade defined a wide range where profits could happen on the upside. But it also leaves a stock alternative where the stock going down after the big move higher is better.
Right now, with the stock 69.50, the trade is worth about 4.50. Intrinsically it is worth $8 here. That means if the stock just stayed here until January expiration, and additional 3.50 in profits would be realized. Of course that intrinsic value changes with the stock. So if the stock goes higher from here profit potential diminishes, and a move lower towards the mid strike and it increases.
One good sign is in the days following the gap higher, the stock has looked like ti wants to consolidate a bit, and hasn’t been moving a ton. That’s good for this trade, especially with some low vol Holiday trading ahead. As far as trade management, upside risk seems greater than downside, since a slight move lower is actually good. So keeping a stop on the upside to take profits a dollar or 2 higher than here makes sense. Whereas a consolidation to 67.50 is ideal and patience will pay off. The entire trade is about -15 deltas here, so that gives a sense of immediate changes to price on moves in the stock in the near term. Those deltas will increase to -100 (starting slowly then increasing closer to Jan expiration) as time goes on as long as the stock is above 67.50. Below 67.50 and the trade is once again bullish as the deltas flip to positive.